Private equity is experiencing a shadow capital boom. Data over the past several years consistently shows co-investment and direct investment appetite is extremely high, suggesting a new normal in dealmaking. Last September, Pitchbook reported global PE direct investment deals more than quadrupled between 2009 and 2013, though demand has dipped a little since (along with the rest of the ambivalent PE market).
Mergemarket surveyed PE funds last year and found 56% actively offer co-investment opportunities to their LPs. In fact, it isn’t unheard of for some of today’s LPs to walk from established sponsors if future co-investment opportunities aren’t part of the package.
This points to a more active, more cost-conscious movement among limited partners and outside investors. According to PwC figures from early 2015, investors of all sizes participate in co-investments. The co-investment movement has important implications, but the first questions ought to be: Why co-investment? And why now?
The Basics of Co-Investments
For those who aren’t familiar, here’s a short refresher:
- Private equity co-investment and direct investment deals exist outside the standard fund structure, where large passive investors pool resources to be managed by a fund sponsor.
- In a standard fund, each investor agrees to give money to a fund sponsor (“general partner” or “GP”) inside of a well-defined private equity partnership. The partnership agreement dictates how the GP allocates capital, asset diversification, investment sizes, exit processes, etc.
- Co-investments bypass the standard LP-GP fund by investing directly in a platform company. The co-investment is technically a minority ownership stake. Many co-investors are already existing LPs.
- Co-investments are still coordinated between fund sponsors and the co-investor, but often at very different terms than those in the standard partnership agreement.
Why Limited Partners Want More Co-Investments
According to a study from ValueWalk, 80% of LPs reported better performance from co-investments than from traditional fund structures. Additionally, 77% preferred small to mid-market buyout strategies and $2-10 million per co-investment. Nearly half of sponsors (49% per the ValueWalk survey) charged no management fee on co-investments in 2015. Just as many didn’t charge carried interest, partially explaining the stronger performance for investors. Given these results, one shouldn’t be surprised when LPs in the middle market show more appetite for co-investment opportunities.
Fees aren’t the only important factor. Robert Durden, managing director at Morgan Creek Capital Management, argues that “costs do drive this for some of the larger investors, especially the new entrants,” but that more established voices “point to their ability to control the pace of capital deployment, mitigate the j-curve, and control their own risk.”
Many new LPs prefer the co-investment model because it adds transparency and trust. The diligence between LP and GP isn’t always smooth, and disagreements over a deal (or asset buckets, or costs) can wreck a good investment. Alternatively, sponsors may float out co-investments to large investors as a sample. This lets the investor learn how the GP does business, how they perform due diligence, etc.
“The quality of a co-investment program reflects the quality of the managers from whom you see the transactions – as well as your ability to select from the deals they offer,” says Dennis McCrary, partner and head of co-investment at Pantheon Ventures.
Limited partners usually pursue co-investments through one of three strategies: investing in Fund of Funds with a small percentage allocated to co-investments; investing in a co-investment-only strategy (usually predicated on strong relationships between sponsors and LPs); or leveraging an opportunity through other investments with the same sponsor.
Why General Partners Might Like Co-Investments
So why would a GP agree to co-investments? At first glance, GPs lose on fee income and give away fund control, making it difficult to see why any give away such opportunities.
The traditional reason GPs offer co-investments is to avoid capital exposure limitations or diversification requirements on a partnership agreement. For example, a $750M fund might pick five platforms, each with an enterprise value around $200M and each with specific diversification characteristics. The partnership agreement might limit fund investments to $125M for each company (meaning the firms would be levered up for the remaining $75M). If a wonderful new possible platform were to show up with an enterprise value at $325M, the GP would need to look outside its standard fund structure to make a move. It can only invest $125M directly and it might borrow another $75 – 125M for financing, then offer co-investment opportunities to existing LPs or outside parties.
To entice them, co-investors are normally offered better terms, maybe a board seat, or some other incentive. Some sponsors stick with the classic 2% and 20% payment structure, but most don’t. In the right circumstances, co-investors get an extra stake in a fund and (normally) far less hassle and lower costs. Sponsors can dilute their risks, raise more capital, and lay the tracks for future deal flow.
Co-investing can also save time on diligence, negotiation, and risk. Increasing deal flow is a major concern in congested markets, and the average co-investment is far less complicated than establishing an entirely new fund or working through an existing LP model. In a 2012 interview, Aaron Rudberg, a director for Baird Private Equity, told Investment & Pensions Europe that co-investment opportunities were “more about building relationships than about deal size.”
No market prices are exempt from competition. The 2-and-20 model is synonymous with PE fund management, but the co-investment and direct investment trends are already reducing the overall average management and carry fee percentages paid by bigger LPs, according to FitchRatings. This could be a major coup for investors who are likely to see returns squeezed in a tightening PE market for 2016 and beyond.